I am an entrepreneur and communications expert from Salt Lake City, founder of Snapp Conner PR, and author of Beyond PR: Communicate Like A Champ The Digital Age, available at http://amzn.to/1AO0PxX. I am also a frequent author and speaker on Business Communication. The opinions I express (especially when tongue in cheek) are entirely my own. My newsletter is the Snappington Post, available at http://bit.ly/1iv67Wk

But I was intrigued by a recent article from Barry Schuler, co-founder and Managing Director of later-stage VC firm DFJ Growth and former Chairman/CEO of America Online. I reached out to Schuler directly to hear his concerns. They are good ones. Schuler warns entrepreneurs about the less obvious reasons to approach crowdfund equity with care.

While crowdfunding won’t require nearly the level of disclosure public companies face, to keep your investors informed and happy you will still need to do regular communications of some variety to keep them all “in the loop”. Whereas traditional early stage funding comes through channels you know and understand – the bank, perhaps, or an angel investment group, or Uncle Ned – with crowdfund equity you may dealing with legions of investors you don’t know and have never met. Worst case, at the very times you need to stay heads down on execution you could be dealing with 50 investors calling you for an update every week. Startups are risky ventures. Statistically, the majority fail. At the very time you will most need supportive voices, you’ll have a set of grouchy individuals clamoring to tell you what to do. Which leads to the following consideration:

Do you really want dumb money?

For the first time, the JOBS act is allowing unsophisticated investors to purchase your stock. Whereas traditional investors are a good source of input – how’s your business plan stacking up, and is a Snuggie for a goldfish really such a brilliant plan – crowdfund investors may invest entirely on emotion, which means the input they provide may only serve as additional negative pressure for you.

A Utah venture recently learned that lesson the hard way. A private company had raised a significant round of funding from non-accredited investors—grandmas, neighbors and private individuals. When the company faltered and it was necessary to pivot, guess the biggest hurdle? The company needed to corral a total of 400 individuals—few of them business savvy—to obtain their support and votes in order to be able to roll. They succeeded, however the effort and anguish it took to marshal and educate the audience was time and resource the company’s management could ill afford to expend.

It is important to consider the concept of “VC math”, Schuler says. “The failure rates of new business are high, even with professionals trying to pick the winners. It would be fair to assume 75 percent of crowd funded investments will go to $zero. How long before the whole model flames out as horror stories circulate of people losing their kids college savings?”

What class of stock will you offer? And what will happen to your early crowdfund investors when you go to traditional institutional investors later on?

Crowdfund equity may be ideal for a smaller business such as a restaurant or a service business that can get itself to profitability on a single funding round. But the majority of companies that become great require multiple rounds of funding at various points on their way. In this case, what class of stock would early crowdfund investors receive? Traditionally, early investors receive preferred stock that ensures their money is first out in a liquidation, and would have “pro-rata rights” to participate in new rounds to prevent their dilution. Also, Schuler notes, for at least the early phases of equity crowdfunding, he imagines VCs would look askance at a company that comes to the table with 100 unsophisticated investors in tow.

Equity and crowdfunding expert David Drake, founder of The Soho Loft, weighed in with me on these little understood challenges for crowdfund equity investors as well. Drake noted FacebookFacebook stock (an example that was illustrated in the popular Facebook movie) as an example of the point Schuler is raising. The way Facebook partner Sevarin was removed (and the resulting lawsuit against Mark Zuckerberg) is a classic case of stock dilution. “Imagine the firm issues 1 billion shares of stock after your initial investment and dilutes you out of a meaningful return or voting position for your original shares?”

The corporation A Small World is another illustrative example Drake raised—in a later stage fundraise the company issued shares of stock as convertible debt. In tough times, the “loan to own” lender exercised its right to convert its position to stock at a reduced valuation and took control of the company—something the original partners had never intended. Drake describes the “loan to own” strategy as one that is familiar in the real estate arena, but much less familiar to start up entrepreneurs who are looking to raise funds within the crowd funding space. The debt a company incurs in a “loan to own” investment is senior to stock, which means that original investors lose their property when the company fails to pay on the loan.

Killing The Goose“As Crowdfunded equity rolls out, what happens if there is blow-back to the existing crowdfunding model?” Schuler asks. “If, instead of going on Kickstarter to buy some new hardware or back an indie movie, investors migrate to crowdfund equity with the expectation that you get ‘a piece of the action’, and not just a T-shirt, what would be the implications for the burgeoning model of non-equity crowdfund investing the U.S. is enjoying today? It is fascinating to contemplate,” Schuler maintains.

However, even in the face of these concerns, Schuler welcomes (as I do) the benefits equity crowdfunding will bring to the plethora of companies that aren’t suited for funding by traditional VCs. Finally, they gain additional options. Tongue in cheek Schuler also pointed to the boon equity crowdfunding presents to the legal industry as so many additional forms of filing and disclosure come forward, and many new avenues of litigation emerge. He points to the boon for professional communicators as well. (Hey! That’s personal… but he does have a point.) To these points, CEO enablement and acceleration company CEO Space is providing education and resources to assist entrepreneurs in addressing the disclosure and filing criteria of crowdfunding (of both the traditional and equity varieties) particularly as the SEC has lifted its ban on general solicitation. The company provides worksheets and materials to help entrepreneurs and their attorneys meet filing requirements here.

Challenges aside, Schuler welcomes the unique new ways for startup ventures to reach critical mass. “In most respects, how a company gets to growth stage is irrelevant as long as it is legal,” he says, “But these entrepreneurs should know that as VCs, we prefer there to have been institutional seed investors because we know they have established good governance right from the beginning. There are other growth investors who like to be the first institutional investors in – meaning the company has bootstrapped. Crowdfunded companies may carry a ‘taint’ on this front.”

If you are sitting on an idea with the potential to become an iconic company, he notes in his Inc. article, “perhaps it is worth it to avoid the unknown ‘force’ until we all know who Luke Skywalker’s dad really is?”

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This article should be required reading before anyone contemplates equity crowdfunding. It is so important to understand that it differs greatly from token/rewards based systems.

I don’t think that equity crowdfunding will replace token systems but will provide an additional avenue for those who are at the point that availing equity makes sense.

Either way, crowdfunding campaigners need to be fully aware of the risks involved and how choices made today will effect their business later. The focus cannot just be to raise capital. Many may need the initial cash infusion by way of investments but what are the overall goals?

Thanks very much, Rachael, and I agree. Barry is one of the most informed interview sources I’ve had the pleasure to speak with as of late. This is perspective every aspiring entrepreneur (and investor) should know. Thanks very much for your note.

As expanded upon in my previous blogs, there is validity surrounding the additional and unexpected consequences of crowdfunding a Startup; “Dumb Money”, Investor Relations, and Dilution. I also concur that legal expenses will increase as Founders become better informed around the SEC’s more onerous rules of engagement.

Keep in mind the SEC’s mandate is to protect non-accredited investors, i.e. the “unsophisticated” working class, from unscrupulous fraudsters and unsuitable investment. If crowdfunding is a 40-ounce can of Old English, the SEC is the thin straw you must drink it through. This restrictive regulatory environment is a cost-of-doing-business; not something to “Game!”

This type of messaging from established VCs and Institution Investors is also expected propaganda. Since the SEC killed small-cap IPOs on secondary markets, the VC “Big Brother” was the only game in town. I understand their concern; the JOBS Act might markedly diminish the quality and velocity of deal-flow.

I project that established VC’s will need to redefine their firm’s differentiated value proposition, highlighted enabling qualities above growth capital. Growth capital is now a commodity. It is time to start selling your service.

In effect, when we hear the derogatory, though often appropriate term “Dumb Money,” Schuler and his peers need to spend some time and energy educating a more competitive marketplace on the definition and value of “Smart Money!”

A well researched and timely article as the buzz on equity crowd funding in the US builds. It points out our position that revenue royalty crowdfunding is in the best interests of many venture planners who seek to retain control of their company, and their sanity, preserve options for later rounds of funding, while offering a true reward for backers who remain engaged after the initial raise. While the crowd may be unsophisticated in investing in startups they know and will evangelize the products, services or causes they love. This puts money in the venture, keeps an engaged and expanding customer base and reduces many of the risks of other methods, particularly when paired with a principal protection program that assures against investor loss in the event royalties fail to live up to expectations.

Yes absolutely . or My next choice is to buy stocks at their post IPO like 2nd hand citizen ( i.e. Facebook) . I guess not . I much rather to buy Local Crowd Funding projects that I can have local investment . Wall street had its chance, I am not going back . Small business is the engine of the economy and employment. I am not the only . Check the state of the IPO in past three years . Get ready for CrowdEconomy .